32 Inflation and Growth: The Phillips Curve We must seek to reduce inflation at a lower cost in lost output and unemployment. JIMMY CARTER Inflation and Growth: The Phillips Curve We must seek to reduce inflation at a lower cost in lost output and unemployment. JIMMY CARTER
●Demand-Side Inflation versus Supply-Side Inflation: A Review ●Applying the Model to a Growing Economy ●Demand-Side Inflation and the Phillips Curve ●Supply-Side Inflation and the Collapse of the Phillips Curve ●What the Phillips Curve Is Not ●Demand-Side Inflation versus Supply-Side Inflation: A Review ●Applying the Model to a Growing Economy ●Demand-Side Inflation and the Phillips Curve ●Supply-Side Inflation and the Collapse of the Phillips Curve ●What the Phillips Curve Is Not Contents Copyright © 2003 South-Western/Thomson Publishing. All rights reserved.
●Fighting Unemployment with Fiscal and Monetary Policy ●What Should Be Done? ●Inflationary Expectations and the Phillips Curve ●The Theory of Rational Expectations ●Why Economists (and Politicians) Disagree ●Fighting Unemployment with Fiscal and Monetary Policy ●What Should Be Done? ●Inflationary Expectations and the Phillips Curve ●The Theory of Rational Expectations ●Why Economists (and Politicians) Disagree Contents (continued) Copyright © 2003 South-Western/Thomson Publishing. All rights reserved.
●The Dilemma of Demand Management ●Attempts to Reduce the Natural Rate of Unemployment ●Indexing ●The Dilemma of Demand Management ●Attempts to Reduce the Natural Rate of Unemployment ●Indexing Contents (continued) Copyright © 2003 South-Western/Thomson Publishing. All rights reserved.
Copyright© 2003 Southwestern/Thomson Learning All rights reserved. ● AD ♦ prices ♦ output ● AS ♦ prices ♦ output ● AD ♦ prices ♦ output ● AS ♦ prices ♦ output Demand-Side Inflation versus Supply-Side Inflation
FIGURE 32-1 Inflation from the Demand Side Copyright © 2003 South-Western/Thomson Publishing. All rights reserved. S S D 0 D 0 Price Level Real GDP A D 1 D 1 B
FIGURE 32-2 Inflation from the Supply Side Copyright © 2003 South-Western/Thomson Publishing. All rights reserved. S 0 S 0 D 0 D 0 Price Level Real GDP A S 1 S 1 B
Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Applying the Model to a Growing Economy ●Usually, AD and AS both grow. ●AD often grows somewhat faster than AS ● When it does, inflation results. ●Usually, AD and AS both grow. ●AD often grows somewhat faster than AS ● When it does, inflation results.
FIGURE 32-3 The Price Level and Real GDP in the U.S., Copyright © 2003 South-Western/Thomson Publishing. All rights reserved. D D S S D D S S ,5009,5009,0008,5008,0007,5007,0006,000 Price Level (GDP deflator) (1996 = 100) Real GDP in Billions of 1996 Dollars 5,5005,0004,5004,0003,500
FIGURE 32-4 AS and Demand Analysis of a Growing Economy Copyright © 2003 South-Western/Thomson Publishing. All rights reserved. S ,360 Real GDP in Billions of 1996 Dollars D 0 D 0 Price Level (1996 = 100) 9,000 A S 1 S 1 D 1 D 1 B
Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Demand-Side Inflation and the Phillips Curve ●If GDP are primarily caused by AD: ♦Higher rates of inflation will be associated with lower rates of unemployment ♦Lower rates of inflation will be associated with higher rates of unemployment ●The U.S. data for show such a relationship. ●If GDP are primarily caused by AD: ♦Higher rates of inflation will be associated with lower rates of unemployment ♦Lower rates of inflation will be associated with higher rates of unemployment ●The U.S. data for show such a relationship.
FIGURE 32-5 The Effects of a Faster Growth of AD Copyright © 2003 South-Western/Thomson Publishing. All rights reserved. D 2 D 2 S 0 S 0 S 1 S ,540 Real GDP in Billions of 1996 dollars C D 0 D 0 Price Level (1996 = 100) 9,000 A
FIGURE 32-6 The Effects of Slower Growth of AD Copyright © 2003 South-Western/Thomson Publishing. All rights reserved. D 3 D 3 S 0 S 0 S 1 S ,180 Real GDP in Billions of 1996 Dollars E D 0 D 0 Price Level (1996 = 100) 9,000 A
FIGURE 32-7 Origins of the Phillips Curve Copyright © 2003 South-Western/Thomson Publishing. All rights reserved. 3.8% % c b Inflation Rate 4%3% e Unemployment Rate
FIGURE 32-9 A Phillips Curve for the U.S., Copyright © 2003 South-Western/Thomson Publishing. All rights reserved. 7% Inflation Rate 1 Unemployment Rate in Percent
Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Supply-Side Inflation and the Collapse of Phillips Curve ●If GDP are primarily caused by AS: ♦Higher rates of inflation will be associated with higher rates of unemployment ♦Lower rates of inflation will be associated with lower rates of unemployment ●The U.S. data for and show such a relationship. ●If GDP are primarily caused by AS: ♦Higher rates of inflation will be associated with higher rates of unemployment ♦Lower rates of inflation will be associated with lower rates of unemployment ●The U.S. data for and show such a relationship.
FIGURE A Phillips Curve for the U.S.? Copyright © 2003 South-Western/Thomson Publishing. All rights reserved % Inflation Rate 1 Unemployment Rate in Percent
Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Supply-Side Inflation and the Collapse of Phillips Curve ●Explaining the Fabulous 1990s ♦Favorable supply shock AS curve shifts out ♦Characterizes the U.S. economy from 1996 to 1998 ■GDP grew rapidly ■Both inflation and unemployment fell ●Explaining the Fabulous 1990s ♦Favorable supply shock AS curve shifts out ♦Characterizes the U.S. economy from 1996 to 1998 ■GDP grew rapidly ■Both inflation and unemployment fell
FIGURE Stagflation from an Adverse Supply Shock Copyright © 2003 South-Western/Thomson Publishing. All rights reserved. Real GDP in Billions of 1996 Dollars 4,9124, S 0 S 0 D 0 D 0 Price Level (1996 = 100) 57 A S 1 S 1 D 1 D 1 B
FIGURE The Effects of a Favorable Supply Shock Copyright © 2003 South-Western/Thomson Publishing. All rights reserved. Price Level Real GDP Effect of favorable supply shock Normal growth of aggregate supply D 0 D 0 S 0 S 0 D 1 D 1 S 1 S 1 B C A
Copyright© 2003 Southwestern/Thomson Learning All rights reserved. What the Phillips Curve Is Not ●Phillips Curve = curve showing a short-run trade-off between unemployment and inflation ♦Only applies if AD ♦Not a stable, long-run menu of choices ●Phillips Curve = curve showing a short-run trade-off between unemployment and inflation ♦Only applies if AD ♦Not a stable, long-run menu of choices
FIGURE The Elimination of a Recessionary Gap Copyright © 2003 South-Western/Thomson Publishing. All rights reserved. Price Level Real GDP S 0 S 0 S 2 S 2 S 1 S 1 D D A B Potential GDP C
Copyright© 2003 Southwestern/Thomson Learning All rights reserved. What the Phillips Curve Is Not ●In the long run, AD : ♦ inflation ♦ But AD does not unemployment ●Long-run effects due to the self-correcting mechanism of the economy ●In the long run, AD : ♦ inflation ♦ But AD does not unemployment ●Long-run effects due to the self-correcting mechanism of the economy
FIGURE The Vertical Long- Run Phillips Curve Copyright © 2003 South-Western/Thomson Publishing. All rights reserved. Inflation Rate Unemployment Rate in Percent g c f e 8% a d
Copyright© 2003 Southwestern/Thomson Learning All rights reserved. What the Phillips Curve Is Not ●Natural rate of unemployment = level of unemployment that is sustainable in the long run ●Corresponds to the “full-employment” unemployment rate ●Natural rate of unemployment = level of unemployment that is sustainable in the long run ●Corresponds to the “full-employment” unemployment rate
Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Fighting Unemployment with Fiscal and Monetary Policy ●Policy choices if high unemployment: ♦Use expansionary fiscal and monetary policy ■ unemployment ■ inflation ♦Rely on economy’s self-correcting mechanism ■ unemployment without inflation ■Problem: may take a long time to reduce unemployment ●Policy choices if high unemployment: ♦Use expansionary fiscal and monetary policy ■ unemployment ■ inflation ♦Rely on economy’s self-correcting mechanism ■ unemployment without inflation ■Problem: may take a long time to reduce unemployment
Copyright© 2003 Southwestern/Thomson Learning All rights reserved. What Should be Done? ●Active versus passive monetary and fiscal policy ♦How the public rates the relative costs of unemployment and inflation ♦Slope of the short-run Phillips curve ♦Efficiency of the economy’s self-correcting mechanism ●Active versus passive monetary and fiscal policy ♦How the public rates the relative costs of unemployment and inflation ♦Slope of the short-run Phillips curve ♦Efficiency of the economy’s self-correcting mechanism
Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Inflationary Expectations and the Phillips Curve ●Inflation does not erode real wages if: ♦Workers can see inflation coming ♦They receive compensation for it ●But if real wages do not fall, firms have no incentives to increase production. ●Inflation does not erode real wages if: ♦Workers can see inflation coming ♦They receive compensation for it ●But if real wages do not fall, firms have no incentives to increase production.
TABLE 32-1 Money & Real Wages under Unexpected Inflation Copyright © 2003 South-Western/Thomson Publishing. All rights reserved.
TABLE 32-2 Money and Real Wages under Expected Inflation Copyright © 2003 South-Western/Thomson Publishing. All rights reserved.
Copyright© 2003 Southwestern/Thomson Learning All rights reserved. ●When inflation is predicted accurately: ♦The short-run AS curve is vertical at potential GDP ♦The short-run Phillips curve is vertical at the natural rate of unemployment ●When inflation is underestimated: ♦ The short-run AS curve and the short-run Phillips curve slope upward ●When inflation is predicted accurately: ♦The short-run AS curve is vertical at potential GDP ♦The short-run Phillips curve is vertical at the natural rate of unemployment ●When inflation is underestimated: ♦ The short-run AS curve and the short-run Phillips curve slope upward Inflationary Expectations and the Phillips Curve
FIGURE Vertical AS Curve and the Vertical Phillips Curve Copyright © 2003 South-Western/Thomson Publishing. All rights reserved. Vertical short-run Phillips curve Inflation Rate (b) Unemployment Rate Vertical aggregate supply curve Price Level (a) Real GDP 5 S S
Copyright© 2003 Southwestern/Thomson Learning All rights reserved. ●Rational expectations = forecasts that are the best that can be made given the available data ♦Not necessarily correct ♦No systematic errors ●Rational expectations = forecasts that are the best that can be made given the available data ♦Not necessarily correct ♦No systematic errors The Theory of Rational Expectations
Copyright© 2003 Southwestern/Thomson Learning All rights reserved. The Theory of Rational Expectations ●If expectations of inflation are rational: ♦The short-run Phillips Curve is vertical ♦Inflation can be reduced without the need for a period of high unemployment ●If expectations of inflation are rational: ♦The short-run Phillips Curve is vertical ♦Inflation can be reduced without the need for a period of high unemployment
Copyright© 2003 Southwestern/Thomson Learning All rights reserved. The Theory of Rational Expectations ●Reasons that expectations are not completely rational ♦Contracts may embody outdated expectations ♦Expectations may adjust slowly ♦Workers likely receive compensation for inflation after the fact ●Reasons that expectations are not completely rational ♦Contracts may embody outdated expectations ♦Expectations may adjust slowly ♦Workers likely receive compensation for inflation after the fact
Copyright© 2003 Southwestern/Thomson Learning All rights reserved. The Theory of Rational Expectations ●In the long run, expectations should be rational. ♦People should not cling to incorrect expectations indefinitely. ●In the long run, expectations should be rational. ♦People should not cling to incorrect expectations indefinitely.
Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Why Economists (and Politicians) Disagree ●Why Keynesians and liberals are more eager to fight unemployment ♦Unemployment is more costly than inflation ♦The short-run Phillips Curve is flat ♦Expectations react sluggishly ♦The self-correcting mechanism is slow or unreliable ●Why Keynesians and liberals are more eager to fight unemployment ♦Unemployment is more costly than inflation ♦The short-run Phillips Curve is flat ♦Expectations react sluggishly ♦The self-correcting mechanism is slow or unreliable
Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Why Economists (and Politicians) Disagree ●Why rational expectations, adherents, and conservatives are more eager to fight inflation ♦Inflation is more costly than unemployment ♦The short-run Phillips curve is steep ♦Expectations react quickly ♦The economy’s self-correcting mechanism works smoothly and rapidly ●Why rational expectations, adherents, and conservatives are more eager to fight inflation ♦Inflation is more costly than unemployment ♦The short-run Phillips curve is steep ♦Expectations react quickly ♦The economy’s self-correcting mechanism works smoothly and rapidly
Copyright© 2003 Southwestern/Thomson Learning All rights reserved. The Dilemma of Demand Management ●Monetary and fiscal authorities cannot avoid the trade-off between inflation and unemployment. ♦True whether inflation is due to a shock to AD or AS ♦Government only has control over AD curve ●Monetary and fiscal authorities cannot avoid the trade-off between inflation and unemployment. ♦True whether inflation is due to a shock to AD or AS ♦Government only has control over AD curve
Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Attempts to Reduce Natural Rate of Unemployment ●The terms of the Phillips Curve trade-off can be improved by policies to lower the natural rate of unemployment. ♦Education ♦Training ♦Job placement services ●The terms of the Phillips Curve trade-off can be improved by policies to lower the natural rate of unemployment. ♦Education ♦Training ♦Job placement services
Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Attempts to Reduce Natural Rate of Unemployment ●Problems ♦Training and placement programs often look better on paper than they do in practice, where they achieve only modest successes. ♦The high cost of these programs restricts the number of workers that can be accommodated, even when they work. ●Problems ♦Training and placement programs often look better on paper than they do in practice, where they achieve only modest successes. ♦The high cost of these programs restricts the number of workers that can be accommodated, even when they work.
Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Indexing ●Indexing = provisions in a law or contract whereby monetary payments are automatically adjusted whenever a specified price index changes ♦Wages ♦Pensions ♦Interest payments on bonds ♦Income taxes ●Indexing = provisions in a law or contract whereby monetary payments are automatically adjusted whenever a specified price index changes ♦Wages ♦Pensions ♦Interest payments on bonds ♦Income taxes
Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Indexing ●Indexing protects people from the costs of inflation. ●But many economists worry that if people do not experience the costs of inflation, they will have little incentive to prevent it. ●Indexing protects people from the costs of inflation. ●But many economists worry that if people do not experience the costs of inflation, they will have little incentive to prevent it.